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FOREIGN TRADE:

The exchange of goods and services between the domestic sector of a given nation and its foreign sector (that is, other nations of the world). Also termed international trade when viewed from the perspective of the global economy, this exchange of production is comparable to any exchange, except that buyers and sellers are from different countries. Key insight from the study of foreign trade includes the law of comparative advantage and trade protection policies.
Foreign trade arises when an economy exchanges of goods and services with its foreign sector. This includes goods and services produced in the domestic economy of a nation and purchased by the foreign sector, what is termed exports, and goods and services produced in the foreign sector and purchased by the domestic economy, what is termed imports.

Foreign trade is also termed international trade. The distinction between the two terms is based on perspective. International trade is viewed from the perspective of the global economy, in which each of the nations of the world are players in the exchange game. Foreign trade is viewed from the perspective of the domestic sector of a given economy. This foreign trade perspective takes a decidedly domestic, geocentric view, that is, "us" (the domestic sector) versus "them" (the foreign sector).

The flow of trade between a given nation and its foreign sector is captured by net exports. Net exports are the difference between exports (goods and services produced by the domestic economy and purchased by the foreign sector) and imports (goods and services produced by the foreign sector and purchased by the domestic economy).

In addition to highlighting the law of comparative advantage, viewing international trade from a domestic/foreign perspective enables a better understanding of the why and how of foreign trade policies designed to promote exports and/or restrict imports, and thus increase net exports. The key foreign trade policies are tariffs, import quotas, and export subsidies.

Domestic and Foreign

Let's first begin by distinguishing between two related terms, foreign and domestic.
  • Domestic: This is activity that takes place within the political boundaries of a given nation. Usually, not always but usually, this activity is undertaken by resources owned by citizens of the nation. The domestic sector, or domestic economy, includes producers, consumers, and even governments residing in the given nation.

  • Foreign: This is, in contrast, any activity that takes place beyond the political boundaries of a given nation, that is, activity in other nations. The foreign sector includes producers, consumers, and even governments from other nations.
Foreign trade is then the exchange of goods and services between the domestic economy and the foreign sector.

Exports and Imports

The direction of the exchange, that is, who does the buying and who does the selling, is generally categorized as either imports or exports.
  • Imports are goods (or services) produced by the foreign sector and purchased by the domestic economy. These are goods (or services) that flow into the domestic economy in exchange for payment that flows out of the domestic economy and to the foreign sector.

  • Exports are goods (or services) produced by the domestic economy and purchased by the foreign sector. These are goods that flow out of the domestic economy in exchange for payment that flows from the foreign sector and to the domestic economy.
With goods and services flowing back and forth between the domestic economy and the foreign sector, a summary, or net, flow of activity is often useful.
  • Net exports are the difference between exports and imports. This is the difference between goods flowing out of the domestic economy and goods flowing into the domestic economy.

Open and Closed

While most nations of the world engage in foreign trade, it is possible, at least in theory, for a domestic economy to have no foreign trade. This suggests two related notions a closed economy and an open economy.
  • Closed Economy: A closed economy is an economy with no foreign trade, meaning that the economy is totally self sufficient. All goods consumed are produced within the domestic economy and all goods produced with in the domestic economy and consumed domestically as well.

  • Open Economy: An open economy is an economy with that engages in foreign trade, meaning that some goods produced by their domestic economy are purchased by other nations and/or some goods purchased in the domestic economy are produced by other nations.

Domestic and Global

The term foreign trade implies one of two ways that the exchange of goods and services among different nations can be viewed. The most common way is from the perspective of the domestic economy. The other way is from the perspective of the global economy.
  • The Domestic View: With this view, the focus is on foreign trade, the flow of trade between the domestic economy and the foreign sector. The domestic economy includes activity that occurs within the political boundaries of a particular nation. The foreign sector is then any and all activity that takes place beyond those political boundaries, activity that takes place in other nations. This view inevitably creates an "us" versus "them" perspective. This is the perspective a dedicated sports fan might take when rooting for the "home" team. Use of the term foreign trade reveals the domestic/foreign, us/them perspective.

  • The Global View: A broader view looks at every nation as but one among many players in the game of international trade, the flow of trade among nations. With this view each nation operates its own domestic economy and is simultaneously part of the foreign sector for every other nation. This is the perspective that an unbiased, objective umpire or referee should take when officiating a sporting event. Use of the term international trade emphasizes this notion of trade among nations.
Is one view right? Is the other view wrong? Is one view better than the other? Yes and no. And maybe. Like a lot that takes place in the study of economics, it all depends. For those who seek to isolate the basic principles of trade among nations, the global view makes the most sense. However, for those who seek to isolate the basic principles of domestic macroeconomic activity, the domestic view generally works better.

While the domestic view distinguishes between imports and exports, the global view sees both as essentially two sides of the same coin. The import of one nation is the export of another. All imports are exports and all exports are imports. And while one nation might have more exports than imports, or more imports than exports, the global economy ALWAYS has a balance between exports and imports. Short of trading with another planet, net exports for the global economy are ALWAYS zero.

The Law of the Comparative Advantage

The key economic principle underlying foreign trade is the law of comparative advantage. This law states that every nation has a production activity that incurs a lower opportunity cost than that of another nation. This means that any given nation is bound to find some production that it can export as well as other production that it can import.

How does this law work? First consider two related concepts.

  • Absolute Advantage: A country is said to have an absolute advantage if it can, in general, produce more goods using fewer resources. An absolute advantage arises when a country is technically efficient or technologically superior.

  • Comparative Advantage: A country is said to have a comparative advantage if it can produce one good at a relatively lower opportunity cost than other goods, compared to the production in another country.
The law of comparative advantage works because EVERY nation has at least one good that it can produce at a relatively lower opportunity cost than that incurred by another nation. This is the key to foreign trade, because it also means that other nations can benefit by importing that good rather than producing it domestically. It's a win-win for exporters and importers.

The Balance of Trade

Tracking the flow of exports and imports, the foreign trade for a country, is commonly accomplished with the balance of trade. The balance of trade is the difference between the value of goods exported out of a country and the value of goods imported into the country. That is, it is the difference between exports and imports.

The balance of trade is essentially another term for net exports, the difference between exports and imports. However, whereas the net exports phrase surfaces in most theoretical analyses of the macroeconomy, the balance of trade term tends to be more common in the official measurement of foreign trade.

In fact, the balance of trade is actually one component of a more extensive set of international financial accounts termed the balance of payments. The balance of payments is the difference between all payments coming into a country and all payments going out of the country. Many of these payments are for exports and imports, but other payments are for capital assets or simply gifts between foreign and domestic citizens.

In the same way that net exports can be either positive or negative, meaning exports exceed imports or imports exceed exports, the balance of trade can have either a surplus or deficit.

  • Balance of Trade Surplus: A surplus in the balance of trade arises if the value of exports exceeds the value of imports. In terms of "payments," this indicates that the domestic economy is receiving a net inflow of payments from the foreign sector. More payments coming in than going out means the domestic economy has more income that enhances the living standards of domestic residents. For this reason, a balance of trade surplus is also commonly termed a favorable balance of trade.

  • Balance of Trade Deficit: A deficit in the balance of trade arises if the value of imports exceeds the value of exports. In terms of "payments," this indicates that the domestic economy has a net outflow of payments to the foreign sector. Fewer payments coming in than going out means the domestic economy has less income and thus lower living standards. For this reason, a balance of trade deficit is also commonly termed a unfavorable balance of trade.

Foreign Trade Policies

Most nations of the globe are inclined to implement trade protection policies. Because all nations prefer a balance of trade surplus with exports exceeding imports, they are inclined to implement policies that restrict imports and promote exports. The three primary government trade policies are tariffs, quotas, and subsidies.
  • Tariffs: One common trade policy is the imposition of tariffs on imports. Tariffs are simply taxes placed on imports. Tariffs work like any other taxes. A tariff or tax is added to the price of the imported good. Suppose, for example, that the price of an imported good is $10. A tariff of $1 would then force importers to sell each good for $11. Domestic producers are usually thrilled with a tariff because the higher price of imports is bound to reduce the quantity of imports sold. This means more domestic production is likely to be purchased. Moreover, domestic producers can also raise the price they charge for their goods.

  • Quotas: An alternative to tariffs is to simply restrict the quantity of imports coming in a country. The technical term for this is an import quota. Quotas are simply restrictions on the quantities of goods imported. In this case, the government stipulates that foreign producers can sell a specific number of imports in domestic economy. While domestic producers would likely prefer setting an import quota at zero, preventing all foreign imports, any restriction is appreciated. With fewer imports entering the domestic economy, more domestic production is sold, and in all likelihood, at higher prices.

  • Subsidies: A third policy is for the domestic government to subsidize a domestic industry facing competition from imports. That is, the government pays domestic producers for each good produced. Subsidies are simply payments from the government to individuals or businesses without any expectations of receiving any production in exchange. Domestic producers usually promote the use of government subsidies as a way to be "competitive" with "lower cost" foreign imports. A subsidy gives domestic producers the ability to produce more goods at a lower price and presumably reduce the number of imports into the country.

<= FOREIGN SECTORFOREIGN TRADE POLICIES =>


Recommended Citation:

FOREIGN TRADE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: January 17, 2018].


Check Out These Related Terms...

     | international economics | international finance | international trade | comparative advantage | absolute advantage | law of comparative advantage | gains from trade |


Or For A Little Background...

     | exports | imports | net exports | foreign sector | specialization |


And For Further Study...

     | balance of trade | balance of trade surplus | balance of trade deficit | balance of payments | international market | foreign trade policies | tariffs | import quotas | export subsidies | terms of trade | foreign exchange market |


Related Websites (Will Open in New Window)...

     | World Trade Organization | North American Free Trade Agreement | General Agreement on Tariffs and Trade | European Union |


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